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CRISIS/ Governments and central Banks caused a huge global Boom in Credit

April Fri 17, 2009

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Governments and central banks around the world pursued policies that, with the benefit of hindsight, caused a huge global boom in credit, pushing up housing prices and financial markets to levels that defied gravity.

(Secretary Geithner Introduces Financial Stability Plan, February 10, 2009)

 

Nobody has given any attention to this short remark by Treasury Secretary Geithner, even though many Libertarians and Austrian economists echo the same message. Geithner himself, in this same February 10 message, refrains from drawing any implications from this fundamental admission of the limits and errors of the centrally planned disruptive excursion into global credit and financial markets. If the crisis was caused by huge excesses of credit and assumption of risk, almost as if there were no threat of a downside, do we really expect to fix anything by doing our best to stimulate a return to excessive credit, debt financed consumption and bailouts to remove the losses resulting from bad risk?

 

And even now with massive repeated and unprecedented bailouts and economic stimulations, (almost) nobody is happy with what the central planners are doing, not even the most recent winner of the Nobel prize in economics and one of the strongest supporters of centralized economic planning and manipulation, Paul Krugman. See What the Obama team is proposing is disconcertingly similar to the actions of Japanese Prime Ministers and The Obama administration is now completely wedded to the idea that there’s nothing fundamentally wrong with the financial system.

 

Geithner's latest plan is the Public-Private Program for Legacy Loans whereby investors can purchase risky assets for 7% of their auction price and hold half of the equity. The government would take the other half of the equity for an equal 7% stake while it would guarantee loans for the remaining 86%. If, for example, some investment bank is holding a risky asset with a face value of $1 billion and a real market value today much, much lower, that same investment bank (perhaps even through some third party) might bid $840 million in this public-private partnership. Thus, with an upfront loss of $160 million and a further investment of 7% ($60 million), this bank can effectively dump their risky asset on the public for net $780 million! Both the upfront markdown and the 50% nominal participation (at a cost of 7%) are, in fact, a very modest price for a very appealing escape from the riskiest of these questionable assets.

 

Nassim Taleb said, in a Blomberg interview, “I don’t understand why I as a taxpayer need to subsidize those who failed, by giving them options so they can rebuild their balance sheets.” He went on to say that it is “shocking” that the government would allow banks to estimate the value of the toxic assets that remain on their books because there is effectively no market for the securities, making them almost impossible to value.

 

Wall Street Journal asked about Treasury's Very Private Asset Fund: Why write the rules to favor only a handful of bidders? “The investment community was already suspicious last week when Secretary Timothy Geithner unveiled his plan, announcing that Treasury would select four or five companies as 'fund managers' to purchase toxic securities. Given that the whole idea is to create a liquid market for these assets, we'd have thought Treasury would encourage as many players as possible. But the bigger shock was when Treasury released its application to become a fund manager, a main rule of which is that only firms that already have a minimum of $10 billion in toxic securities under management can apply.”

 

So, only the biggest (potential) sellers are allowed to participate in this shift of risky assets. They can bid high for the assets that they themselves sell, taking all of their profit up front from the government participation and government guaranteed loans. On the other hand, there will be the most limited competition, likely to refrain from bidding up the risky assets currently held by smaller investors who aren't allowed to participate in the auction.

 

I am convinced that we should not want to, nor could we possibly even hope to, recover the huge exaggeration in debt-funded consumption that fueled our recent boom. Private individuals and corporations all want to reduce their debt and risk. Only the government has the unlimited budget that permits overlooking all risk. Furthermore, the greatest risk and temptation to government and bureaucracy is the consolidation and concentration of power, control, and central planning. This converges perfectly with the hope in the state to save the economy. Hillary Clinton (among others) was recently quoted as saying, “Don't waste a good crisis.”



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